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Benchmark matters

August 11, 2013

While there is little of substance to report this past week from the financial markets, I want to alert you to an often missed but essential component of every trade and investment: the benchmark aka currency to measure an asset. Whether it’s a stock, commodity or property, we see thousands of prices every day but hardly question whether the “measuring stick” changes or not. Focusing on nominal price changes while neglecting the big picture is quite dangerous in a global economy where the real picture is what matters.

For example, let us look at the structural change of government’s share of the US economy versus private income over the past forty years.

Government spending vs. Income

As you can see, a major structural change from a small government economic system to large government “involvement” has occurred in America. While this chart in itself is worth many discussions, I will refrain from the obvious political opinions regarding the issue as this is a financial blog. From a financial point of view, one would think that the enormous growth in government should have an effect on that government’s currency($) and its debt(Treasuries). Sure enough, let us look at those two indicators of government health.

US dollar index

First, the dollar index has fallen gradually over the past forty years against other currencies around the globe. But here again, every currency the $ is measured against must be viewed separately to understand the full picture.  Finally, how about 10 year Treasuries over that period of rapid government expansion?

Ten Year Treasury yield

As you can see, the Ten Year yield is at rock bottom of the forty-year time frame discussed. As yields are inverse from prices, this means that we have all time highs in government bonds at a time when government itself has become the largest entity in the economy. While this may not change over night, the status quo is undoubtedly an extreme financial condition and will likely lead to (counter) reactions in both currencies and interest rates in the future. As the prices for bonds and currencies change so will the price and value of all assets that are quoted nominally. Extreme prices, as we observe today, usually lead to a period of high volatility so buckle up!

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